Friday, March 25, 2011

Why the Stimulus Failed to Boost Infrastructure in the US: A Comparison With China

The data are now clear. Despite its large size, the 2009 U.S. stimulus package failed to increase government infrastructure spending or other government purchases as its promoters had claimed it would. The large federal stimulus grants sent to state and local governments for infrastructure spending were mainly used to reduce borrowing and thus did not result in an increase in purchases. Here is a summary of my research with John Cogan. The explanation is that local governments in effect acted as many American households did: when they received the stimulus money, they saved it rather than purchased goods and services. This is what permanent income theory would predict. It is also what previous empirical studies of the 1970s stimulus packages found.

To better understand this explanation one can look at other countries, and in particular at China’s recent stimulus package. This week I went to China and explored the question.

Local governments in China apparently did increase infrastructure spending in 2009 following the stimulus package. Why didn’t these governments simply reduce borrowing as did U.S local governments? Professor Chong-en Bai of Tsinghua University gave me the best answer using simple economic reasoning: the local governments appeared to behave more like liquidity constrained households than permanent income households. In China, local governments do not have much access to capital markets. They get their funding mainly from the central government, including loans from the central bank, and of course only for projects that are approved by the central government. At any point in time local governments are submitting new infrastructure projects for approval; some are being rejected and some are being accepted. If the central government wants to increase infrastructure spending by the local governments all it has to do is lower the acceptance criterion, instruct the central bank to provide the funds, and the volume of projects increases. This is apparently how the stimulus worked in China.

Note that the mechanism is essentially built into the structure of the economy, with characteristics similar to an automatic stabilizer in which the criteria are raised and lowered administratively according to the state of the business cycle. Of course, if the criteria before the stimulus were appropriate, then the projects accepted during the stimulus were of more dubious quality.

This hypothesis has yet to be tested, however. The type of data published by the U.S. Bureau of Economic Analysis—which John Cogan and I used to study the stimulus in the United States—are not publicly available in China, so alternative empirical tests will have to be devised.